Saturday, February 6, 2010

Themes For 2010 - 6 - Final Thoughts

Last month, I ran a series of pieces detailing my outlook for credit markets, the economy, asset markets, and government interventions in them.

The overarching theme was that a secular shift had occurred in 2007 toward the reduction of debt and leverage within our economies. 2008 was the point of recognition. In 2009, we experienced a barrage of "fix-its." Most of these programs were designed to either conceal the actual problem, transfer the obligations to others, and to otherwise re-instill confidence in asset price valuations. The natural tendency for market participants to fluctuate between pessimism and optimism resulted in the perception that these programs had worked and that "normalcy" had returned.

But our concept of "normal" had been skewed by the previous secular shift, which was anything but normal. Its duration of over 3 decades was sufficient to eliminate the memories of how a normal economy actually functions. Indebtedness had replaced the role of savings; speculation the role of investment; consumption the role of production.

A number of factors enabled this shift: the fall of Soviet Russia, globalization, productivity enhancing technological advancements, booming demographics, and most importantly, the implicit and explicit government guarantees doled out to the financial services industry.

A number of those factors have reached their points of maximum impact. Others are already reversing. The first baby boomers began retiring in 2007. The impact of this will increasingly show its effects on markets as they liquidate their assets to pay for their retirements. Globalization grew to the point that the social ramifications of its imbalances will force a retrenchment. The cyclical nature of international trade is well documented. And technological progress, while it will always continue, has not experienced the type of long-term investment necessary to garner returns seen in the 90's and 00's.

The only constant is change. But while most are afraid of change, I prefer to embrace it. Every decade sees enormous secular shifts in our markets, yet most analysts, pundits and economists spend a majority of their time trying to figure out how we can avoid, or blunt the effects of such shifts. It is an exercise in futility. I don't expect to be able to alter people's irrational fear of change. I can only point to it in hopes that some can capitalize on it early.

I will reprint the conclusions from the previous installments in this series.

On the whole, credit markets have not recovered. In fact, in many areas credit quality has continued to deteriorate unabated. A pending supply of low grade mortgage recasts, along with an overhanging inventory of underwater mortgages will likely force a continuing deterioration in loan performance and further house price declines. Despite accounting shenanigans that allow banks to value their assets at whatever they like, banks' lending ability remains constrained, while the ability and willingness to borrow is also under pressure. The overall amount of debt outstanding is also constraining the economy's ability to lend its way out of the recession. Even with historically low rates, the high level of debt gives us a servicing ratio that constrains our ability to invest in productive capacity.

We are most likely (as of June '09) in the midst of a technical recovery as defined by GDP. But this masks the rot underneath the surface. Consumer credit and income growth are contracting. As such, personal consumption expenditures will likely remain depressed for some time. Short term gimmicks like "cash for clunkers" and homebuyer tax credits may provide incentives for consumers to delay their deleveraging, but the cost of the programs add to the overall debt burden, which needs to be paid with interest. High debt servicing burdens hinder our ability to invest. In the long run, these programs are detrimental to GDP - even though they may provide relief in the near term.

Structurally high unemployment will likely persist, as those who have recently fallen out of the workforce will join it again upon improving job market fundamentals. This will serve as a drag to economic robustness, but should keep wage pressures low for a considerable amount of time. Declining wages will increase productivity and likely bring about a revival in the US goods-producing industries that have shed jobs for 3 decades.

The picture I have painted above is very deflationary. Combined with contracting credit markets, valuations of financial assets should decline to reflect their weak earnings potential. I will discuss the implications of a rebalancing economy and contracting credit on asset markets later this week.

A vast majority of the $23.6 Trillion in bailouts, swaps and guarantees has been directed toward supporting home prices. For the most part, they have failed. The natural course is quite obviously for home prices to continue declining toward levels commensurate with incomes and revenue generation ability. The expiration of many temporary "kick the can down the road" schemes, along with a flood of Option-ARM and Alt-A recasts, will significantly hamper bank balance sheets and eventually force further credit writedowns. Populist anger toward big bank favouritism will also limit the government and the Fed's ability to enact further legislation favourable to banks.

Credit contraction and asset price deflation are two peas in the same pod. As I believe credit contraction is unavoidable over the long-term, I also see lower asset prices ruling the roost. In many cases, a return to historical valuation levels would imply drastic reductions in prices. This should be viewed in a positive light. Lower asset prices enable lower wages, which restore competitiveness and lays the foundation for a robust economic recovery. Whether this happens in 2010 is to be determined. But I feel that the probabilities are strongly in favour of such a scenario.

With all that in mind, I'll proceed to my "Themes for 2010." The normal qualifications are required. Some of these themes will be correct, others will be laughably false. Such is the nature of prediction in a dynamic system. Many of these themes are very long-term in their nature. While pressures may build, many may not necessarily "peak" in their effects until many years down the road. For example, this will be the third year that I have highlighted the stresses in state and municipal governments. I have not necessarily been wrong in the past two years, as the problems have continually grown in both their size and realization in the mainstream. Indeed, it will likely take many more years for a long-term solution to be found. Such is the case with much of the below.

- a resumption in the trend toward deleveraging and falling prices for most liquid assets (stocks, commodities and corporate bonds)- a consequent rise in the US Dollar Index, perhaps very substantially so as credit contracts- decreasing global trade and a continuation in protectionist measures, primarily directed toward China- outright collapse of China's bubble-economy as foreign capital flees. Chinese officials blame everyone but themselves- movement toward surplus for America's trade deficit- sovereign debt concerns roil Europe, the Middle East and perhaps even Japan- state and municipal debt concerns accelerate, pitting unions and pensioners vs. everyone else- another leg down in North American real estate prices - especially Canada's largest markets- growing dissent within the Obama Administration as populist anger disables government's favourable treatment of the FIRE industry ahead of midterm elections- falling salaries for sports stars and actors/entertainers as discretionary spending wanes on event tickets- relative bright spots will include South America (specifically Brazil, Chile, Colombia and Peru) and personal wireless devices. - the US manufacturing industry begins a revitalization

Regardless of what happens, I wish my readers a prosperous 2010!

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7 comments:

You think deflation is most likely, and "This should be viewed in a positive light. Lower asset prices enable lower wages, which restore competitiveness and lays the foundation for a robust economic recovery".If so, sovereign debt is guaranteed to default, as GDP, taxes, and other sources of government income will collaps.This also means that e.g. pensions and pension funds, who are heavily invested in "safe" bonds will partly default on their pension obligations. Not to mention China's US Tbill possessions.Governments cannot let this happen. It will be destructive for decades.Is it really conceivable that scenario will play out.

I know. I sounds far-fetched. And by no means do I expect this to occur anytime soon. It will take many years yet.

But looking back at history, we can see that government default on their obligations is a fairly regular occurrence. The US, UK, Germany, France and Japan have all done so in one manner or another throughout their history - often as a result of war.

Only through enormous hubris have we come to believe such an event is impossible today. In fact, it is usually shortly after it is claimed that the business cycle has been conquered that we are forced to learn the hard way. Think Fisher's proclamation of a "permanently high plateau" in 1929, or Bernanke's "Great Moderation" speech in 2006.

Matt you haven't said too much on the Canadian Real Estate market lately. I have a good friend and RE agent in Mississauga who is a lot busier now then he was a year ago. Back then he was almost looking for other work. And he also says there are lots of buyers right now but few sellers. I know that's just his opinion, but do you have any updates on what you think is going on?